Some public leaders and financial industry experts are pushing to have the definition of an “accredited investor” changed by raising the minimum income and net-worth requirements. The move would make it more difficult for the mass-affluent to invest in hedge funds, which proponents of the rule change believe will provide greater investor protection. Others question whether the rule really protects investors at all.

“I think the standard needs to be updated,” said Massachusetts Secretary of State William Galvin, speaking this week on a hedge fund panel in New York. Galvin, who made headlines two weeks ago when he criticized hedge funds as too risky for pension funds to invest in, said that he believes hedge funds are increasingly targeting unsophisticated retail investors unaware of the risks associated with this type of investment vehicle.

According to Rule 501(a) of Regulation D, an accredited investor is an individual with income in excess of $200,000—or joint spousal income of $300,000—for the two most recent years, if the individual reasonably expects to earn at least the same amount in the current year. A person with a net-worth of over $1 million is also considered an accredited investor.

Galvin said that in the 24 years since the rule was penned, the S&P 500 has risen tenfold and housing prices have skyrocketed, yet the amount of money an investor must have to qualify as “accredited” has remained unchanged.

According to the National Association of Securities Analysts Association, 7.4% or 7.5 million American households have a net worth of between $1 million and $25 million, making them eligible to invest in hedge funds.

“I fear many of these people don’t have the financial sophistication [to understand the risks],” said Galvin.

Michael Butowsky, a partner in Mayer, Brown, Rowe & Maw’s corporate practice who was speaking on the same panel as Galvin, said that before the rule is changed, it should first be determined if the rule is useful at all.

“If the premise for the net-worth part of the accredited investor test was good in ’82, it is good now,” he said, but added, “some in the industry have questioned whether judging an investor solely by his net-worth is a valid test of financial sophistication.”

Paul Weisenfeld, senior v.p. and director of Smith Barney Alternative Investments, is one of those who is questioning the effectiveness of the law. “We clearly should not be equating eligibility to suitability,” said Weisenfeld, speaking on the same panel. Instead, he thinks that it is more important for advisors to focus on how liquid the investments are and how well-suited an investor is for a particular investment strategy.

He also said that given the relative illiquidity of the asset class, while the eligibility standards may not always reflect the investor’s level of investment sophistication, the net worth of an investor does play a role in determining suitability because the wealthier the client, the better equipped he or she is to manage the infrequent liquidity periods and potential investment lock- ups.

“What is required is a client who can plan,” said Weisenfeld, explaining that a hedge fund investor, much like a private equity investor, has to understand that their money may be tied up for a longer time than if they were just invested in stocks.

Ryan Tagal, director of hedge funds and alter- native investments at Morningstar, the firm known for ranking mutual funds, said that the firm doesn’t have a position on whether or not the rule should be changed, but has observed cases where a client’s net-worth has no correlation to his or her investing savvy.

“In our experience, we have seen very high-net-worth investors who need help and small investors who are very sophis- ticated…our goal is to help both of them make the best investment decisions,” Tagal said. “Though I suspect the rule will be changed.” Whether or not the bar is raised to become a qualified investor, Tagal doesn’t see it having much of an affect on retail investors because he believes hedge funds are really targeting institutions and wealthy individuals.

“It is true that most hedge funds are not targeting retail clients,” Tagal said. “Most hedge funds are looking for larger investment chunks and a base that they don’t have to spend too much time explaining their structure.”

Weisenfeld agrees, saying that in general he does not think hedge fund firms are targeting retail clients. “I think some asset management firms with hedge fund and fund-of-hedge fund strategies may be targeting retail investors. But high-quality hedge funds and funds-of-hedge funds are far more interested in making money and generating alpha for clients, not gathering assets through retail distribution,” said Weisenfeld.

Definition of an Accredited InvestorThe federal securities laws define the term accredited investor in Rule 501 of Regulation D as:

a bank, insurance company, registered investment company, business development company, or small business investment company

an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million

a charitable organization, corporation, or partnership with assets exceeding $5 million -a director, executive officer, or general partner of the company selling the securities

a business in which all the equity owners are accredited investors

a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase

a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year

a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes

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